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Institutional investor profile: Gus Long, Managing Partner, Fort Washington Capital Partners

Long on the attractions of specialist funds, on the dangers of following the crowd, on the effect of Sarbanes-Oxley on smaller companies, on the acceptance of private equity as an asset class and on the disclosure debate.

Based in Cincinnati, Fort Washington Capital Partners is a fund of funds manager with just under $700m under management. The firm is affiliated to The Western and Southern Life Insurance Company, which has been investing in private equity since 1984. The fund of funds programme was set up in 1999 and invests capital from the life insurance group and from third parties. Fort Washington Capital Partners currently manages three funds of funds and is about to launch a fourth with a target of between $100m and $200m. It invests across the full range of private equity, mainly in the US, with a specific focus on specialist funds. Long joined the firm in 1999 from the private equity finance group at BT Alex. Brown.

What type of investments do you look for?
‘We look to build a well balanced, well diversified portfolio. But the primary driver is our preference for managers who specialise in one, possibly two, industries. We look for funds that have a deep-seated franchise in a particular industry. We have chosen this strategy for a variety of reasons. We believe - and this is true of all parts of the economic cycle, but especially so in down markets - that specialisation gives the team an edge.

‘If you have eaten, drunk and slept a particular industry, you will have a better understanding of the industry dynamics. So, if you are assessing a business strategy or the viability of a new technology, a deep knowledge of that industry is going to be a plus. Secondly, if you have spent your life in an industry, then your personal relationships in that business are going to be stronger. That means the team is able to conduct their due diligence to a much better standard and far more deeply. To paraphrase one of our GPs when doing due diligence on a potential investment: “We don't ask the friends of the company we're researching, we ask our friends.” The third point is that the team will make more informed valuation decisions - and this has been particularly relevant over the last few years. Better evaluation decisions are going to earn you better returns. A good company is not necessarily a good investment. If it's a great company, but you pay too much for it, then it could turn out to be a poor investment.

‘Another point relates to the assessment of management talent. There are certain characteristics that you would look for in management teams across all industries, but there is also an industry-specific component to that. A lot of the service providers have built their practices around specialisation - the investment banks, the search firms, lenders, etc. GPs who specialise will have credibility with these third parties and therefore get better access to good deals and to capital for those deals.

‘The one drawback to that strategy is that it limits you in terms of the amount of money that you can commit. So, while specialist funds are our focus, we have to look at our overall portfolio construction. Even if we thought that we had the five best life science players in the world, for example, we couldn't invest solely in those. We try to diversify across styles, stage, by industry and by year. We also diversify by geography, although we invest primarily in the US. We can commit up to 20 per cent of our funds outside the US and today, that really means Europe and Asia as far as we are concerned. We have had some investments in Latin America in the past, but there is too much uncertainty there for us at the moment.'

What do you look for in a fund manager?
‘Given our strategy, our number one requirement is industry expertise. That makes due diligence a little easier for us because we are focused on a group of people within that industry. Beyond that, we look at the chemistry of the team. Unlike public equities, in private equity you are making a very long-term commitment to a particular organisation - and we're doing that on behalf of our limited partners. We want to be sure that the team will work well together over the long term.

‘The other thing that we look at is the ability to add value. There was a time when it was possible for buy-out firms to be very successful through financial engineering. We certainly benefited from some of that success. But that is much tougher to do these days. So we want to see teams that have the ability to bring more to the table than just capital. Again, that's where having a specialised strategy can help.

‘None of this is an exact science. It would be great if you could just boil this down to a set of equations that would show you what would produce the optimum result. But it's not like that. You just have to assess the quality of the team and on top of that, look for some original thinking or unique approach to sourcing, investing or adding value.'

How do you find out about investments?
‘The key is to be proactive about sourcing new opportunities. As the industry matures, you are increasingly finding brand names that have done very well, but many of them are facing succession issues. So you have to be constantly on the look-out for newer investment opportunities. You need to have a core group of established funds in your portfolio, but you have to be aware of the teams that are spinning out and new ones that are forming. This business has a large element of “connect the dots” to it. It's a networking business. It's our job to know who the top one, two or three players are in a particular segment so that we have a pool to draw from - their timing may not always coincide with ours, after all.'

Does that mean you have a healthy appetite for first-time funds?
‘We are more than willing to look at first-time funds; we are not willing to look at first-time investors. You have well established investors that have been working together for years. That is one camp. You then have the team that has left a firm, but that has worked together for a long time. When you do the due diligence on this type of fund, you have to be sure that the track record the team is claiming matches up with what the firm it has spun out from says. Most importantly, it must also tally with what the CEOs and CFOs involved say about who was really doing the deal. Lastly, you have the teams made up of seasoned investors who may not have worked together for long. That is the most complicated to unravel. This gets back to assessing the chemistry of the team. The last thing in the world that we want to do is commit to a fund and find that the team disintegrates three years into the process.'

What frustrates you about the market?
‘I get particularly frustrated by the general tendency of people to follow the crowd and then get cold feet exactly at the time they ought to be continuing to invest. What drives success? In any asset class, those who have been successful have been those who have not become enamoured with particular areas and who have recognised that the key is a steady investment pace over a long period of time. People who put a lot of money to work during the bubble, but who are shying away from investing today have violated that principle. That doesn't mean that people shouldn't have put money to work in 1999 - I fundamentally believe that you cannot time equity markets - it means that they should have remained consistent.

‘I couldn't have predicted in 1999 that we were at the peak of a bubble in the same way that I cannot predict today that we are at the bottom of the cycle. But what I can say is that we are in a bearish environment at the moment. If you look at the great investments that have come out of private equity, many of them were made at very difficult times of the market. I'm not suggesting that investors pour money into the asset class now. I'm simply saying that they should not be retracting. Rather than chasing markets, investors should stay on the steady path of investment.'

What's your view on the disclosure debate currently unfolding in the US?
‘I don't object to the disclosure of fund returns as long as people have been educated as to the pattern of returns you typically find in private equity. People must understand the J-curve, otherwise the raw data is meaningless. The typical pattern is that the value of the fund is going to go below par before investors start seeing returns. At the peak of the bubble you would see the “six times your money in six months” syndrome. There was no J-curve and valuations simply kept on going higher. As a consequence, newer investors simply assumed that this was normal. But it wasn't. It was totally abnormal for private equity. Anyone who has been in this business for an extended period of time will understand that. So if you are going to disclose returns, you have to ensure that the general public, such as the members of the pension schemes, understand that.

‘However, I am dead set against disclosure at the portfolio company level. Private companies are private for a reason. Many of them are in the early stages of their life cycle. They have competitive challenges against established players and they don't need someone ferreting out negative press about them.'

What is the biggest issue in the market?
‘I think it's helpful to split this into short and long-term issues. Over the short term, the biggest issues are the overhang of capital that has been raised by firms and that needs to put to work and the overhang of investments that have been made, but that have no near term prospect of realisation. But I do believe that, as with any imbalances, these issues will eventually work themselves out.

‘But over the longer term, I have concerns about the impact of the Sarbanes-Oxley Act. This is really an attempt by the government to regulate after the event. It is more relevant to the venture capital sector, but it does apply to some extent to buy-outs, too. In order for companies to go public, they need coverage. If they do not get coverage by Wall Street analysts, it makes it very hard for smaller companies to go public. The concept of Sarbanes-Oxley - that officers and directors of public companies should be subject to a greater degree of accountability - is a good one. But the problem is that it affects smaller companies disproportionately. If you are a huge conglomerate, there are large costs associated with complying with Sarbanes-Oxley, but you have enough net income to cover those costs. Our fear is that it is much harder for smaller companies to go public under these rules because they have to recruit new directors and they have to find someone to head up their audit committee - not a job you'll find many people clamouring for at the moment. My question is this: To what extent will these costs imposed on companies seeking to go public impact their ability to do so? I would implore those responsible for the implementation of these regulations to be cognisant of this.'

How do you think that the market will change in the future?
‘If you go back 15 or so years, private equity was largely funded either by the big pension funds in buy-outs or on the venture capital side, by high net worth individuals and university endowments and foundations. It has now broadened out to become an accepted asset class. Given the fact that expectations for public equities have lowered across the board, there will be an appetite among investors to commit to private equity as a way of boosting their overall returns. Private equity can offer them a premium over the public markets, whatever level they are at.

‘The industry will continue to mature and develop. I don't think that we will return to the investment levels we saw in 1999 and 2000 any time soon, but it is pretty clear that private equity is now established as an asset class and is not going to disappear.'

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